Impact of higher interest rates on UK commercial property - M&G Investments
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For Investment Professionals only
July 2018
Impact of higher interest rates on UK
commercial property
• Gradual transition towards a comparatively lower “new normal” for interest rates
• Relationship between property yields, interest rates and bond yields is nuanced and complex
• Spread between property and bond yields, 75 bps above long-term average: cushion to protect
property in higher bond yield environment
• Capital values supported by market-specific factors during periods of rising bond yields
• Stock selection and effective asset management to drive rental growth and healthy returns
The UK has recently seen some positive macro factors, such There has been much speculation about the frequency with
as stronger employment and rising real wages, but alongside which rate rises will occur, underscored by the health of the
easing inflation, a cooling housing market and more moderate UK economy and inflation above the Central Bank’s 2%
economic growth. While these mixed economic messages target. We expect the BoE to pursue a strategy of policy
have resulted in a somewhat hesitant response from the Bank normalisation, involving a gradual transition towards a
of England (BoE) over tightening monetary policy, the comparatively lower “new normal” for interest rates. Since the
consensus still expects interest rates to rise this year. start of 2017, five-year interest rate swaps in the UK have
remained between 0.5% and 1.5%, implying that markets do
Given this expectation, this paper looks at the potential not expect rates to return to higher levels deemed to be
implications of rising interest rates for the UK real estate “normal” before the financial crisis.
market by assessing the nuanced relationship between bond
and property yields and looking at recent experience in the US
Lessons from the US
market. Our analysis suggests that interest rate rises and
increases in bond yields do not automatically have a linear
In the US, where interest rates have been rising since late
impact on property yields, and that market-specific factors can
2015, and at a more rapid pace than anticipated in the UK,
provide support to capital values during such periods.
current market expectations on US long-term rates still remain
low relative to pre-financial crisis levels. That said, the spread
Transition to “new normal” for interest rates between US and UK bond yields is now at its highest since
2008.
Five-year interest rate swaps (%)
US property market
Source: Bloomberg, Bank of England.
Source: Bloomberg, PMA.
Looking at the correlation between property yields and interest Relationship between property and bond
rates more closely, arguably asset-class-specific factors can
often impact the outcome. This more nuanced relationship is
yields nuanced
shown by the recent experience of the US property market,
Looking at the UK, correlation analysis based on data over
following the Fed’s initial rate hike in December 2015.
the last 20 years shows an equally weak relationship between
Comparing prime yields for New York offices against 10-year
property yields and bank rates or gilt yields. This analysis
US treasury bonds as an example, rising interest rates have so
includes lagging bond yields and interest rates to varying
far not caused any major detrimental impact to US property
degrees to take account of the slow moving nature of property
yields, although the yield spread between the two has
valuations. In all cases, property yields (both MSCI average
narrowed.
equivalent yields and prime net initial yields) show a
correlation with bonds and interest rates which sits well below
the 0.7 watermark dividing a moderately positive relationship
from a strong one. In many cases, the correlation is near-
zero.
Correlations 1998 - 2017
MSCI All Property Prime All Property MSCI All Property Prime All Property
Gilt yield Gilt yield (Lagged
Equivalent Yields Net Initial Yields Equivalent Yields Net Initial Yields
(unlagged) by one quarter)
(%) (%) (%) (%)
10-year gilt yields 0.47 0.33 10-year gilt yields 0.47 0.33
Bank rates 0.24 0.11 Bank rates 0.16 0.03
Gilt yield MSCI All Property Prime All Property Gilt yield (Lagged MSCI All Property Prime All Property
(Lagged by six Equivalent Yields Net Initial Yields by one year) Equivalent Yields Net Initial Yields
months) (%) (%) (%) (%)
10-year gilt yields 0.42 0.30 10-year gilt yields 0.49 0.36
Bank rates 0.14 0.01 Bank rates 0.11 -0.03
Source: Bank of England, Bloomberg, MSCI, CBRE, data to end December 2017.
Regression analysis estimating the relationship between bond yields and property yields shows broadly similar trends to the
correlation data. In fact, gilt yields and bank rates have historically accounted for less than 50% of the shift in MSCI property
yields. This type of analysis alone, however, oversimplifies a complex relationship that cannot be easily explained without
considering other drivers of property values.
Property values supported by macro and market fundamentals
Rising interest rates typically occur during periods of economic growth (or expectations of this) and higher inflationary pressures.
Real estate assets tend to perform well in such environments, as occupier confidence increases and businesses expand,
providing support to rental growth and therefore boosting commercial property values. Certain occupiers may also be committed
to inflation-linked leases, which means rental income will grow at least in line with inflation, supporting overall returns.
Capital value growth and 10-year gilt yields
Source: MSCI Monthly Index, May 2018.
Looking back at the impact of rising gilt yields on property Healthy risk premium priced into UK
capital values since 1989, in nearly all of the seven periods
where bond yields have risen by at least 100bps, property property
values have also appreciated, supported by modest levels of
rental growth. Whilst economic downturns in the early 1990s Given the relative pricing of property to government bonds –
and 2008 reversed this growth, in all other cases property the risk-free rate – the current pricing gap relative to history is
values have held steady or continued to rise, while yields also an important factor influencing future property
have typically flattened out. This relationship highlights the performance. The yield spread between property and
impact of rental growth and market-specific demand and benchmark 10-year gilts moderated during 2017, as long-term
supply fundamentals as key drivers of property values. bond yields have priced in rising interest rate expectations.
However, this spread, at the all property level, remains
Business investment intention survey (coming year) significantly above the historical average by 75bps, with a
healthy risk premium of 420bps priced in (as at March 2018).
Property yield spread over UK 10-year gilts (bps)
Source: Bank of England, Q2 2018.
Market factors should be considered when assessing future
Source: IPD Quarterly Index March 2018.
interest rate and bond yield movements relative to property.
The current supply of space in the UK is at near record lows, The current risk premium is more or less the same across
except for the central London office market. Construction each of the major sectors, as average property yields have
levels, which were yet to fully recover following the Global
recently converged. This is largely reflective of structural
Financial Crisis, have fallen further due to Brexit uncertainties,
change driven by e-commerce growth affecting the retail and
with prime vacancy rates in many cases now less than 3% industrial sectors, driving pricing for the two in opposite
(JLL). UK occupier markets also appear to be in surprisingly directions. The strength of the industrial sector, supported by
good health, which has underpinned 2% p.a. rental growth accelerating rental growth and significant yield compression,
over the 12 months to May 2018, according to the MSCI All has seen the industrial spread move to just 10bps above its
Property Index. long-term average. The retail spread by comparison is 140bps
higher than its long-term average. Given the re-rating in
The latest data from the BoE suggests that UK businesses market yields is driven by long-term structural drivers, this
remain cautiously optimistic. With sentiment for both the relationship is likely to persist going forward. No matter which
Manufacturing and Services sector running above their long- sector, bond yields will need to rise significantly before UK
term average, it is likely that businesses will continue to invest real estate becomes relatively unattractive, although the
in their property needs, taking up more space. The outlook for currently wide risk premium is likely to narrow over the next
rents is therefore for growth to continue, which should help to few years.
support values in the medium term, with income being a key
driver of future UK property total returns. This remains
consistent with history, with approximately 70% of returns
UK real estate a global asset class
generated by the MSCI’s All Property Index attributable to
As UK property becomes an increasingly global asset class,
income returns during the period between 2008 and 2017.
the volume of global capital flows is also likely to distort the
impact of domestic monetary policy changes. Central London
offices, and more recently both regional offices and industrial
assets, have become key targets for international investors
looking to diversify outside of their home countries into ‘safe-
haven’ assets in markets backed by strong structural trends.
Share of UK investment volumes by country of origin transparency – ranked first globally according to JLL’s
Transparency Index 2018 - and relative value versus other
global assets. With global capital flows at near record highs,
investor interest in core UK cities should help to prevent
significantly higher property yields over the medium term.
Mitigating the impact of rising interest rates
We expect future total returns for UK property to be
increasingly driven by income return and rental growth, with
the prospects for capital growth arising from further yield
compression more unlikely. Careful consideration during the
property selection process, as well as effective active asset
management, will be fundamental in driving rental growth,
supporting property values and overall returns. M&G Real
Estate’s investment strategy is to target both core and value-
add opportunities within sectors and markets, which stand to
benefit from above-average rental growth. Our build-to-core
Source: Property Data, 2018. development approach has sought to take advantage of the
Recent Sterling appreciation may cool international capital current lack of high quality assets across much of the UK, at a
flows to a certain extent, but it remains over 18% down versus time of resilient occupational demand. Should interest rates
the Dollar when compared to the last 30 years. UK real estate rise in line with current market expectations, we believe these
also offers a wealth of advantages, including diversification, fundamentals will support rental growth and capital values
across our portfolio.
Recent developments within the M&G Real Estate portfolio
Source: M&G Real Estate 2018.
Summary
Despite much speculation over the pace with which interest rates will rise, we expect the next moves by the BoE to be gradual.
Market-implied estimates would suggest the UK will transition towards a comparatively lower “new normal” for interest rates over
the next five years.
However, statistical analysis on historical data suggests there is not a linear relationship between property and bond yields. With
supportive occupier market fundamentals in most sectors, we would not expect modest, gradual rises in interest rates to lead to a
significant increase in property yields. A focus on sectors and assets with the greatest scope for income growth, alongside
proactive asset management and taking selective development risk, will help cushion any impact of rising rates and aid
investment performance.
For more information
Alex Lund Robert Heaney
Senior Associate: Property Research Director: Institutional Business—Nordics
T: +44 (0)20 7548 6555 T: +46 7 0266 4424
E: alex.lund@mandg.com E: robert.heaney@mandg.co.uk
Stephanie Lin Stefan Cornelissen
Associate: Property Research Director: Institutional Business, Benelux, Nordics & Switzerland
T: +44 (0)20 3480 5849 T: +31 (0)20 799 7680
E: Stephanie.lin@mandg.com E: stefan.cornelissen@mandg.co.uk
Richard Gwilliam Manuele de Gennaro
Head of Property Research Head of Institutional Distribution—Switzerland
T: 44 (0)20 7548 6863 T: +41 (0)43 443 8206
E: Richard.gwilliam@mandg.com E: manuele.degennaro@mandg.com
Lucy Williams
Director: Institutional Business—UK and Europe
T: +44 (0)20 7548 6585
E: lucy.williams@mandg.com
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